There’s plenty to think about when making changes to the ownership of your business. One thing you shouldn’t ignore is the structure of the ownership transaction. It’s important to understand the structure as well as what it means for you and your business.
Generally speaking, there are two types of ownership transactions: the sale or purchase of stock, or the sale or purchase of company assets. This blog post focuses on stock ownership transactions and what you should know about them.
There are two ways you could structure a stock ownership transaction:
1. Corporate redemption and issuance
In this type of structure, your company buys the shares of the departing shareholder (redemption). If a new stockholder or existing shareholder wished to acquire these shares, there would be a share issuance from the company.
2. Stockholder-to-stockholder (cross-purchase)
This structure occurs when one shareholder buys out some or all of the exiting shareholder’s ownership directly from them. When this happens, the transaction won’t appear on your company’s financials, as the transaction is between two stockholders.
Expect different accounting outcomes
Corporate redemption and issuance
When your company buys the shares of the departing stockholder, the payment occurs (via loan or cash) and the accounting adjustment offset for it results in a decrease to the company’s equity. This impacts the company’s financial statement metrics, which in turn could confuse financial statement users who are analyzing your company’s loan covenants and/or bonding capacity.
Less sophisticated users of financial statements may not have the patience or accounting background to inquire about or understand the why there is low or negative equity on your company’s financial statements.
I’ve encountered this issue with users (both potential customers and state licensing boards) who review companies’ financials as a pre-qualifier to work with them. In most cases, they are simply looking to check a box on their pre-qualification forms and have only a bright-line guidance for how financials should appear. True, providing an explanation to certain financial statement users may help to avoid confusion, but not all users are willing to try to understand.
Stockholder-to-stockholder (cross-purchase)
As I mentioned above, an adjustment will not be recorded on your company’s financial statements for a stockholder-to-stockholder transaction. However, if the purchasing stockholder plans to receive funds from your company to pay the other stockholder, this could cause an issue for some financial statement users.
Also, something to consider when planning your company’s cash flow: If the debt that is expected to be funded by your company isn’t on the balance sheet, it could easily be overlooked.
Expect different tax outcomes depending on entity type
There are pros and cons to each of the aforementioned transaction structures, including those related to taxes. Your company’s entity type will determine which tax implications could come into play.
Some examples of differences for tax are potential for gain exclusions, the tax rate the transaction income is taxed, the potential deduction acceleration for the new owner, and the potential for a step up in basis.
Talking with a CPA before the transaction is complete can help you avoid unwanted tax surprises.
Life insurance could become a factor as well
If the ownership transaction occurs due to the death of a stockholder, the way life insurance is set up—if it’s shareholder-to-shareholder or corporate redemption—could affect the tax, structure, and accounting outcomes.
Consider your options
You don’t get to re-do ownership transactions, so it’s important to do it right. Be sure to consider your options well ahead of the event and consult with a CPA to weigh the tax implications. If you have questions about the best ownership transaction structure for your business, we can help. Contact us today.